How Credit Utilization Can Hurt Your Credit Score

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One of the most important factors in your credit score is credit utilization, or how much of your credit limits you use at a given point. This scoring factor can be easily gamed by managing your account balance for your benefit, helping you achieve a higher credit score by paying down your balance and being smart with your credit limits.

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Why credit utilization matters

The whole goal of the credit scoring algorithms is to determine how likely it is that someone will default on his or her obligations in the next six or 12 months. To that end, credit utilization is a pretty reliable indicator that a borrower is encountering financial stress.

Suppose we have two people, each of whom has a credit card with a $10,000 credit limit. One person has a balance of $8,000. The other person has a balance of $500.

With only this information in hand, which person do you think is most likely to have a budget shortfall, or encounter problems paying back his or her balances? I suspect you'd answer that the person with the larger balance is the person most likely to have budget problems right now or in the future. I agree.

Credit bureaus use credit utilization as a scoring factor because it allows them to leverage the knowledge of the banking industry to determine a borrower's riskiness. If a bank is willing to lend someone only up to $10,000 (the credit limit), and the borrower has $8,000 of outstanding balances, the odds are relatively high that the borrower is getting to the point at which his or her balances will become a very big problem, both personally and for the bank.

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Some people fall through the cracks

Credit utilization has a flaw in that it can really harm people who have low credit limits. Not too long ago, a friend reached out to me, concerned about how low his credit score was despite having a good record of paying his bills on time, and in full.

His curse? His only credit card -- a starter credit card he had opened years earlier -- had a tiny credit limit that had never been increased. As a result, each month his routine purchases sent his credit utilization ratio well above the 30% utilization limit that is generally regarded as the upper limit for a "good" credit utilization ratio.

It doesn't take much spending to use too much of a low credit limit. If your credit limit is only $500, then it would take only a $150 balance to reach the point at which any further spending would start to hurt your credit score in a very big way.

A $400 balance, by no means unrealistic for someone who uses a credit card for daily purchases, would result in an 80% credit utilization ratio. At that point, you're almost assured to experience a pretty big ding to your credit score because of your utilization.

How to fix a credit utilization problem

If you have to have a problem on your credit report, pick credit utilization. Compared with late payments, or other derogatory marks, a credit utilization problem can be fixed quickly by employing several different methods.

Here are four ways to fix a bad credit utilization ratio:

  1. Stop using cards before a credit check. Credit card companies typically report your credit card balance to the credit bureaus once per month. Thus, if you pay off your card in full, and then wait a month before applying for credit, your utilization ratio will be 0% when the lender pulls your credit report and score. Credit utilization only matters at the most recent point in time. Thus, you can fix a bad utilization ratio in about a month's time by paying off your credit card and putting it in your sock drawer. (For the record, the friend I mentioned earlier used this method, and his credit score skyrocketed just a month after paying off his card.)
  2. Ask for a credit limit increase from your card company. Most card companies allow cardholders to ask for a credit limit increase on their cards every six or 12 months. Increasing the credit limit (but not your spending) will reduce your utilization ratio at any given point. If you have a secured card, consider increasing your credit limit by making a larger deposit.
  3. Open another credit card. Utilization is calculated on each account, and across the entirety of your accounts (all of your balances divided by all of your limits). Opening another account can help you increase your total credit limits, thus helping you decrease your total credit utilization ratio. In addition, applying for another card may help you get a larger credit line than asking for a credit limit increase. (Some companies are stingier with credit limit increases on existing accounts than initial credit limits on new accounts, so you might want to apply for a credit card from a different company to get the biggest increase in your total credit limits.)
  4. Pay off your card frequently. Making payments on your card twice per month rather than once is a good way to ensure your balance doesn't grow to become a large percentage of your credit limit. For the perfectionists of the world, consider using a common online banking feature that allows you to set up alerts to notify you by text or email when your card balance reaches a particular level. If your credit limit is $2,000, you might set up an alert to notify you when your balance reaches $500 (25% utilization), so that you can quickly pay it back down before it crosses the 30% level.

Credit utilization may seem unimportant, but it can have a huge impact on the rates you receive on a mortgage or car loan, or whether you're approved at all. 

I ran the numbers on a 30-year fixed mortgage for someone with a 660 FICO score and someone with a 720 or better FICO score. The difference in payments amounted to about 10% of the loan amount over the life of the loan. On a typical $200,000 mortgage, optimizing your credit utilization before you apply could be the difference between putting $20,000 in your pocket or the bank's pocket.

Now that you know how credit utilization works, you know how to game the system to get the best score before submitting your next credit or lease application.

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